Thinking through tax rates

As people work on their tax returns, they would do well to spend a couple of minutes before they finish calculating their tax rates. This is important information that may surprise many taxpayers and could affect routine decisions they make about their investments and lifestyles.

The first calculation is simply the mean or average tax rate. This is the tax you owe on line 62 of the 1040 form divided by the income figure on line 22. (To be more accurate, you should also add income for tax-exempt bonds on line 8b.)

This is important because many people delude themselves into thinking that they aren?t actually paying any taxes if they end up with a refund. But a refund just means that you had too much money withheld from your paycheck. You need to be aware of the amount you really paid: withholding less any refund or plus the check you had to write to the Internal Revenue Service.

A more important tax number takes a little effort to calculate. It?s what is called the marginal tax rate, which is the tax you paid on the last taxable dollar you earned. This number will probably be well higher than your average tax rate. To find the marginal rate, take your taxable income from line 42 and see where you fall in Table 1, which shows marginal tax rates for married couples filing jointly.

The marginal tax rate is critical for knowing the after-tax rate of return on different types of investments. For example, lately the spread between taxable bonds and tax-exempt bonds has been about 19 percent. Thus, if you are in the 10 percent or 15 percent marginal tax bracket, you should not buy municipal bonds. You would be better off buying taxable bonds. Those in higher brackets should do the reverse.

According to the Tax Policy Center, the vast bulk of taxpayers either pay no federal income taxes at all or are in the 10 percent or 15 percent marginal tax brackets. However, growing numbers of taxpayers are finding that something called the Alternative Minimum Tax is raising their marginal rate.

Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.

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